Prime, HELOCs and New Kitchens

You're feeling more secure about your job, so you decide to renovate your outdated 1970s kitchen. Your bank quotes you a $10,000, five-year Home Equity Line of Credit ("HELOC") loan of prime interest rate (aka "prime") 1. Prime is 3.25% as of July 22, 2009. The prime interest rate in the U.S., which can change at any time, is set by the country's largest banks and reported by the Wall Street Journal. The rate is based on the federal funds rate that is set by the Federal Reserve. The federal funds rate is the interest rate at which banks and other depository institutions lend money to each other, almost always on an overnight basis. The federal funds rate is also used to control the supply of available funds and hence, inflation and other interest rates.

Primed
At prime minus 1, what will your monthly HELOC payment be? Your rate to start will be 2.25% (derived from 3.25% - 1%). The cost to you is $176 a month for the interest payment only; but remember you also have to pay off the principal and the longer that takes the more interest expense you'll have. Under these terms, as rates rise, so will your monthly payment. Is the new kitchen worth it?

Is it Worth It?
You can only answer that question with some research. What would the new kitchen add to the selling price today? More than the amount of the loan plus the interest payments? (Hint: for kitchens and bathrooms, the payback is almost always more than the cost of the improvement unless you go crazy with extremely expensive gadgets.)

Which Pot
If it's just a matter of wanting a new kitchen because it makes life easier for you, then you can disregard the resale value numbers in favor of buying yourself a better lifestyle, and that's a matter of deciding whether the increased expense is affordable and won't cause financial problems. However, if you don't care about increasing the value of your home, you should probably try to use savings instead of a Line of Credit (or use the Line of Credit for some minor percentage of the cost if your savings don't cover the cost).

The Point
A Line of Credit is a bad idea unless the point of using it is to gain back the cost of the interest through an increase in value. A Line of Credit must never be used to cover regular living expenses, or to buy something that doesn't have a financial payback down the road. Even at a low interest rate, if you use Line of Credit funds to pay regular bills or buy non-appreciating products, you're paying considerably more than the real worth of each bill payment or purchase, which is like taking the money that went into the interest payments and putting it in the barbeque grill and burning it.